The Fed Credit Alarm Rings! Former New York Fed President warns inflation target of 2% has been breached for five years "Volcker era" rate cut logic is becoming increasingly weak.

Former New York Fed President Bill Dudley recently warned in a media interview that the Federal Reserve is facing a major risk of losing its credibility in fighting inflation after failing to achieve its 2% inflation target for a long time. Dudley said, especially with the new Fed Chairman nominated by President Trump, Kevin Warsh, there may be pressure from the President to cut interest rates against the tide, which could further exacerbate the Fed's credibility crisis. Dudley, speaking on the "Surveillance" program on Tuesday, stated, "Our inflation data has been significantly above the Fed's 2% inflation target for over five years." "And there is a risk that inflation expectations may indeed become completely unanchored." These latest remarks by the former New York Fed President highlight a series of major challenges facing new Fed Chairman Kevin Warsh. Warsh is expected to chair his first Federal Open Market Committee (FOMC) interest rate policy meeting next month. As Warsh takes over the Fed, the Consumer Price Index (CPI) just recorded its largest monthly increase since 2023, and prior to this, President Trump had continued to attack former Fed Chairman Jerome Powell for not significantly easing monetary policy as he requested. Dudley stated that preliminary consumer confidence surveys from the University of Michigan show that long-term inflation expectations are rising, a view echoed by Fed Governor Christopher Waller, who recently emphasized the two-year inflation outlook. Despite interest rates being at or above current levels since November 2022, the U.S. economy continues to demonstrate resilience as it approaches levels expected for full non-farm employment, leading Dudley to question whether the Fed's monetary policy has any restrictive effect. It is understood that Fed Governor Waller, a Trump-nominated Fed official who had previously advocated for rate cuts to protect the U.S. labor market, stated last Friday that the Fed's next move could be a rate hike rather than a rate cut. Dudley also added that the neutral interest rate level, the rate that neither restricts nor stimulates the economy, may structurally be higher than assumed by Fed officials. He also mentioned the unprecedented investment boom driven by artificial intelligence technology, and the increasing levels of U.S. government debt, particularly the latter is reducing savings available for investment in the entire U.S. financial system. Overall, Dudley stated that Warsh's official assumption of the Fed helm, along with President Trump's long-standing calls for Fed rate cuts, are further complicating the credibility challenge the Fed faces. Dudley said, "If the Fed's independence is not questioned, inflation expectations are more likely to remain well anchored." "The reasons for cutting rates right now are actually very, very weak." The dream of rate cuts gives way to hawkish policy bets! The U.S. bond yield curve flashes a "Higher-for-Longer" warning In fact, as the largest inflation data surge since 2023 triggered by the Middle East Iran war continues to rise, traders in the global bond market are actively pricing in the trend that the Fed is almost certain to begin raising interest rates before December, as reflected in the bond market traders pricing in almost 100% certainty that the Fed will raise rates by 25 basis points before December. This marks a sharp reversal from just three months ago, when the market bet on the Fed under Warsh's leadership was expected to cut rates more deeply in the future. This shift reflects the impact of geopolitical turmoil, U.S. economic resilience, and the AI investment frenzy driving the stock market higher. All these factors are increasing concerns that inflation may remain above the Fed's 2% target for a period of time. In a volatile trading week, the two-year U.S. bond yield, most sensitive to Fed policy expectations, briefly climbed to 4.14% last Friday, its highest level in over a year, and nearly 40 basis points above the upper end of the Fed's benchmark interest rate range. The 30-year U.S. bond yield briefly touched 5.2% last week, hitting that level for the first time since 2007, before retreating to 5.06%. The 10-year U.S. bond yield, known as the "global asset pricing anchor," briefly rose to around 4.7% last week, the highest since January 2025, before falling back to around 4.5%. The bond market no longer fully believes that global central banks, including the Fed, can smoothly resume rate cuts, but rather, through the rise in short-term bond yields and a flattening yield curve, are forcing the re-pricing of policy rate expectations back to "Higher-for-Longer" or even "returning to a rate hike cycle." Bond market traders and interest rate futures traders are increasingly betting that under the leadership of new Fed Chairman Kevin Warsh, due to the return of inflation pressure to consumer view, the Fed may maintain high benchmark interest rates for longer (the so-called "Higher-for-Longer" hawkish monetary policy path). Senior strategist Andrew Ticehurst of Nomura Securities stated, "Both data and political factors indicate that the pressure on the Fed to cut rates is significantly weakening, with short-end bond yields re-pricing higher, highlighting the increasing market bets on rate hikes." He added, Trump's comments about letting Warsh do "what he wants to do" are also helping. The 2% inflation target has been elusive, and Warsh's "rate cut + balance sheet contraction" path is facing a reality check There is no doubt that Dudley's assessment is consistent with Warsh's proposal to "restore the Fed's credibility": both recognize that if the Fed cannot bring inflation back to 2% in the long run, its policy credibility and ability to anchor inflation expectations will be compromised. Dudley explicitly warned that U.S. inflation has been above the Fed's 2% target for over five years, and if the Fed's independence is questioned due to political pressure, inflation expectations are more likely to become unanchored; he also believes that the current reasons for cutting rates are "very, very weak." This is in line with Warsh's direction to reshore the central bank's credibility after taking office, but it also means that it will be difficult for Warsh to successfully implement his long-standing "rate cut + balance sheet contraction" monetary policy proposition in an environment of rising inflation, oil price shocks, and expanding long-term U.S. bond yields. Rate cuts will weaken credibility in fighting inflation, while balance sheet contraction may further push up long-term risk premiums and long-term yield curves on U.S. financial markets, increasing long-term borrowing costs; "rate cut + balance sheet contraction" can theoretically be packaged as "front-end easing, back-end normalization," but under current macro conditions, it is easy for the market to interpret it as conflicting policy goals. The more realistic path is: if Warsh wants to restore credibility, in the short term, he must prioritize maintaining hawkish credibility. In other words, not rushing to restart rate cuts and taking a more cautious approach to the pace of balance sheet contraction. Fed Governor Waller recently stated that inflation risks mean the Fed should not continue to suggest rate cuts, and he even did not rule out suggesting the next move could be a rate hike. Nomura Securities recently chose to withdraw its forecast for rate cuts in 2026, citing reasons such as high oil prices brought about by the Iran conflict and a slew of inflation and financing pressures resulting from record AI capital expenditures. Nomura Securities had previously expected the Fed to cut rates by 25 basis points in September and December, but now emphasizes that inflation still has strong stickiness and casts doubt on policymakers' ability to consistently support rate cuts. Wall Street giants such as Morgan Stanley and Barclays Bank have already ruled out the possibility of a rate cut by the Fed this year, citing higher oil prices related to geopolitical conflict in the Middle East and the drag brought by the strong U.S. economy still on a resilient growth trajectory.